Over the past decade, the S&P 500 (^GSPC 0.30%) has been on a terrific run. The benchmark large-cap index has generated a total return of 300% (as of Friday). That gave it a compound annual growth rate of about 14.9% -- meaningfully higher than its long-run average of about 10%. Investors have reaped the rewards.
However, the market appears to be heading into a less common phase, and it would be a good idea for investors to pay close attention.
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The S&P 500 trades at a steep valuation
Investors who have had their money tied up in diversified stock portfolios will have no complaints about the market's strong gains over the past decade. But there is a clear reason to be more vigilant about the current environment and where things are headed.
The S&P 500 now trades at a very expensive valuation. The CAPE ratio -- aka, the cyclically adjusted price-to-earnings ratio or the Shiller P/E ratio -- gauges today's stock prices against the average inflation-adjusted earnings from the prior 10 years. And the index currently has a CAPE ratio of 40.7. It has been lower at every point in the history of the S&P 500 except for during the dot-com bubble of 1999 and 2000. (Data goes back over a century.) A decade ago, the CAPE ratio was at 24.2, so the market has gotten a 67% boost solely from valuation expansion.
Past trends show that the market's valuation has a strong inverse correlation with its returns over the next decade. Research from Invesco, a large asset-management firm, reveals that when the CAPE multiple is around 40 -- as it is today -- the S&P 500's annualized total returns in the subsequent 10 years have been in the negative low-single-digit percentages. For the index to generate its historical average total return of 10% per year, the starting CAPE ratio should be around the mid-to-high teens.
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Focus on these powerful trends
Looking at those patterns from the perspective of the present market can be discouraging. Investors might assume it's time to be cautious. However, there are some powerful trends that have worked in the market's favor in recent years, and that could continue driving long-term returns.
For example, passive investing in index funds has brought in massive amounts of money into stocks. In late 2023, the value held in passive funds exceeded that of actively managed funds for the first time. The democratization of access to quality research, coupled with commission-free brokerage platforms and low-cost funds, has also given retail investors better access to the stock market.
What's more, we've seen tech enterprises dominate the economy. These megacaps are some of the most outstanding companies ever. They have global user bases, durable competitive advantages, scalable business models, and huge free cash flows. They continue to get bigger because they have the capital to invest in growth opportunities. And they are riding some powerful secular trends, most notably artificial intelligence.
The macroeconomic environment has also helped. In about half of those 16 or so years since the Great Recession struck, the Federal Reserve has kept its benchmark federal funds rate close to zero. The other half of the time, that interest rate has still been at historically low levels. That provided an accommodative backdrop for the economy. It also supported ongoing currency debasement (driven by rising federal debt and a growing money supply), which pumps more liquidity into the system, benefiting certain asset classes.
As long as these potent tailwinds remain in play, I don't think investors should worry too much about the CAPE ratio. Of course, this doesn't mean fundamentals and valuations don't matter. These are always important variables to incorporate when making investment decisions. It's just that the stock market of today is operating in a structurally different environment than it was in past cycles. Always keep this knowledge in the back of your mind when forecasters suggest it's time for extreme fear about the S&P 500's prospects.
